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Contents
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1. Learning Outcome Statements (LOS)
2. Study Session 5—Financial Reporting and Analysis (1)
1. Reading 14: Intercorporate Investments
1. Exam Focus
2. Module 14.1: Classifications
3. Module 14.2: Financial Assets, Part 1
4. Module 14.3: Financial Assets, Part 2—Impairments,
Reclassifications
5. Module 14.4: Investment in Associates, Part 1—Equity Method
6. Module 14.5: Investment in Associates, Part 2
7. Module 14.6: Business Combinations: Balance Sheet
8. Module 14.7: Business Combinations: Income Statement
9. Module 14.8: Business Combinations: Goodwill
10. Module 14.9: Joint Ventures
11. Module 14.10: Special Purpose Entities
12. Key Concepts
13. Answer Key for Module Quizzes
2. Reading 15: Employee Compensation: Post-Employment and Share-Based
1. Exam Focus
2. Module 15.1: Types of Plans
3. Module 15.2: Defined Benefit Plans—Balance Sheet
4. Module 15.3: Defined Benefit Plans, Part 1—Periodic Cost
5. Module 15.4: Defined Benefit Plans, Part 2—Periodic Cost Example
6. Module 15.5: Plan Assumptions
7. Module 15.6: Analyst Adjustments
8. Module 15.7: Share-Based Compensation
9. Key Concepts
10. Answer Key for Module Quizzes
3. Reading 16: Multinational Operations
1. Exam Focus
2. Module 16.1: Transaction Exposure
3. Module 16.2: Translation
4. Module 16.3: Temporal Method
5. Module 16.4: Current Rate Method
6. Module 16.5: Example
7. Module 16.6: Ratios
8. Module 16.7: Hyperinflation
9. Module 16.8: Tax, Sales Growth, Financial Results
10. Key Concepts
11. Answer Key for Module Quizzes
4. Reading 17: Analysis of Financial Institutions
1. Exam Focus
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2. Module 17.1: Financial Institutions
3. Module 17.2: Capital Adequacy and Asset Quality
4. Module 17.3: Management Capabilities and Earnings Quality
5. Module 17.4: Liquidity Position and Sensitivity to Market Risk
6. Module 17.5: Other Factors
7. Module 17.6: Insurance Companies
8. Key Concepts
9. Answer Key for Module Quizzes
3. Study Session 6—Financial Reporting and Analysis (2)
1. Reading 18: Evaluating Quality of Financial Reports
1. Exam Focus
2. Module 18.1: Quality of Financial Reports
3. Module 18.2: Evaluating Earnings Quality, Part 1
4. Module 18.3: Evaluating Earnings Quality, Part 2
5. Module 18.4: Evaluating Cash Flow Quality
6. Module 18.5: Evaluating Balance Sheet Quality
7. Key Concepts
8. Answer Key for Module Quiz
2. Reading 19: Integration of Financial Statement Analysis Techniques
1. Exam Focus
2. Module 19.1: Framework for Analysis
3. Module 19.2: Earnings Sources and Performance
4. Module 19.3: Asset Base and Capital Structure
5. Module 19.4: Capital Allocation
6. Module 19.5: Earnings Quality and Cash Flow Analysis
7. Module 19.6: Market Value Decomposition
8. Module 19.7: Off-Balance-Sheet Financing and Changing Accounting
Standards
9. Key Concepts
10. Answer Key for Module Quizzes 189
3. Topic Assessment: Financial Reporting and Analysis
4. Topic Assessment Answers: Financial Reporting and Analysis
4. Study Session 7—Corporate Finance (1)
1. Reading 20: Capital Budgeting
1. Exam Focus
2. Module 20.1: Cash Flow Estimation
3. Module 20.2: Evaluation of Projects and Discount Rate Estimation
4. Module 20.3: Real Options and Pitfalls in Capital Budgeting
5. Key Concepts
6. Answer Key for Module Quizzes
2. Reading 21: Capital Structure
1. Exam Focus
2. Module 21.1: Theories of Capital Structure
3. Module 21.2: Factors Affecting Capital Structure
4. Key Concepts
5. Answer Key for Module Quizzes
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3. Reading 22: Dividends and Share Repurchases: Analysis
1. Exam Focus
2. Module 22.1: Theories of Dividend Policy
3. Module 22.2: Stock Buybacks
4. Key Concepts
5. Answer Key for Module Quizzes
5. Study Session 8—Corporate Finance (2)
1. Reading 23: Corporate Performance, Governance, and Business Ethics
1. Exam Focus
2. Module 23.1: Corporate Performance, Governance, and Business
Ethics
3. Key Concepts
4. Answer Key for Module Quiz
2. Reading 24: Corporate Governance
1. Exam Focus
2. Module 24.1: Corporate Governance
3. Key Concepts
4. Answer Key for Module Quiz
3. Reading 25: Mergers and Acquisitions
1. Exam Focus
2. Module 25.1: Merger Motivations
3. Module 25.2: Defense Mechanisms and Antitrust
4. Module 25.3: Target Company Valuation
5. Module 25.4: Bid Evaluation
6. Key Concepts
7. Answer Key for Module Quizzes
4. Topic Assessment: Corporate Finance
5. Topic Assessment Answers: Corporate Finance
6. Formulas
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LEARNING OUTCOME STATEMENTS (LOS)
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STUDY SESSION 5
The topical coverage corresponds with the following CFA Institute assigned reading:
14. Intercorporate Investments
The candidate should be able to:
a. describe the classification, measurement, and disclosure under International
Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2)
investments in associates, 3) joint ventures, 4) business combinations, and 5)
special purpose and variable interest entities. (page 1)
b. distinguish between IFRS and US GAAP in the classification, measurement, and
disclosure of investments in financial assets, investments in associates, joint
ventures, business combinations, and special purpose and variable interest entities.
(page 1)
c. analyze how different methods used to account for intercorporate investments
affect financial statements and ratios. (page 30)
The topical coverage corresponds with the following CFA Institute assigned reading:
15. Employee Compensation: Post-Employment and Share-Based
The candidate should be able to:
a. describe the types of post-employment benefit plans and implications for financial
reports. (page 37)
b. explain and calculate measures of a defined benefit pension obligation (i.e., present
value of the defined benefit obligation and projected benefit obligation) and net
pension liability (or asset). (page 39)
c. describe the components of a company’s defined benefit pension costs. (page 43)
d. explain and calculate the effect of a defined benefit plan’s assumptions on the
defined benefit obligation and periodic pension cost. (page 49)
e. explain and calculate how adjusting for items of pension and other postemployment benefits that are reported in the notes to the financial statements
affects financial statements and ratios. (page 53)
f. interpret pension plan note disclosures including cash flow related information.
(page 54)
g. explain issues associated with accounting for share-based compensation. (page 57)
h. explain how accounting for stock grants and stock options affects financial
statements, and the importance of companies’ assumptions in valuing these grants
and options. (page 58)
The topical coverage corresponds with the following CFA Institute assigned reading:
16. Multinational Operations
The candidate should be able to:
a distinguish among presentation (reporting) currency, functional currency, and local
currency. (page 65)
b. describe foreign currency transaction exposure, including accounting for and
disclosures about foreign currency transaction gains and losses. (page 66)
c. analyze how changes in exchange rates affect the translated sales of the subsidiary
and parent company. (page 68)
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d. compare the current rate method and the temporal method, evaluate how each
affects the parent company’s balance sheet and income statement, and determine
which method is appropriate in various scenarios. (page 68)
e. calculate the translation effects and evaluate the translation of a subsidiary’s
balance sheet and income statement into the parent company’s presentation
currency. (page 77)
f. analyze how the current rate method and the temporal method affect financial
statements and ratios. (page 84)
g. analyze how alternative translation methods for subsidiaries operating in
hyperinflationary economies affect financial statements and ratios. (page 91)
h. describe how multinational operations affect a company’s effective tax rate. (page
95)
i. explain how changes in the components of sales affect the sustainability of sales
growth. (page 96)
j. analyze how currency fluctuations potentially affect financial results, given a
company’s countries of operation. (page 97)
The topical coverage corresponds with the following CFA Institute assigned reading:
17. Analysis of Financial Institutions
The candidate should be able to:
a. describe how financial institutions differ from other companies. (page 107)
b. describe key aspects of financial regulations of financial institutions. (page 108)
c. explain the CAMELS (capital adequacy, asset quality, management, earnings,
liquidity, and sensitivity) approach to analyzing a bank, including key ratios and
its limitations. (page 109)
d. describe other factors to consider in analyzing a bank. (page 119)
e. analyze a bank based on financial statements and other factors. (page 121)
f. describe key ratios and other factors to consider in analyzing an insurance
company. (page 125)
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STUDY SESSION 6
The topical coverage corresponds with the following CFA Institute assigned reading:
18. Evaluating Quality of Financial Reports
The candidate should be able to:
a. demonstrate the use of a conceptual framework for assessing the quality of a
company’s financial reports. (page 137)
b. explain potential problems that affect the quality of financial reports. (page 138)
c. describe how to evaluate the quality of a company’s financial reports. (page 142)
d. evaluate the quality of a company’s financial reports. (page 142)
e. describe the concept of sustainable (persistent) earnings. (page 145)
f. describe indicators of earnings quality. (page 145)
g. explain mean reversion in earnings and how the accruals component of earnings
affects the speed of mean reversion. (page 147)
h. evaluate the earnings quality of a company. (page 147)
i. describe indicators of cash flow quality. (page 150)
j. evaluate the cash flow quality of a company. (page 151)
k. describe indicators of balance sheet quality. (page 151)
l. evaluate the balance sheet quality of a company. (page 151)
m. describe sources of information about risk. (page 153)
The topical coverage corresponds with the following CFA Institute assigned reading:
19. Integration of Financial Statement Analysis Techniques
The candidate should be able to:
a. demonstrate the use of a framework for the analysis of financial statements, given a
particular problem, question, or purpose (e.g., valuing equity based on
comparables, critiquing a credit rating, obtaining a comprehensive picture of
financial leverage, evaluating the perspectives given in management’s discussion
of financial results). (page 165)
b. identify financial reporting choices and biases that affect the quality and
comparability of companies’ financial statements and explain how such biases
may affect financial decisions. (page 167)
c. evaluate the quality of a company’s financial data, and recommend appropriate
adjustments to improve quality and comparability with similar companies,
including adjustments for differences in accounting standards, methods, and
assumptions. (page 184)
d. evaluate how a given change in accounting standards, methods, or assumptions
affects financial statements and ratios. (page 186)
e. analyze and interpret how balance sheet modifications, earnings normalization, and
cash flow statement related modifications affect a company’s financial statements,
financial ratios, and overall financial condition. (page 177)
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STUDY SESSION 7
The topical coverage corresponds with the following CFA Institute assigned reading:
20. Capital Budgeting
The candidate should be able to:
a. calculate the yearly cash flows of expansion and replacement capital projects and
evaluate how the choice of depreciation method affects those cash flows. (page
203)
b. explain how inflation affects capital budgeting analysis. (page 209)
c. evaluate capital projects and determine the optimal capital project in situations of
1) mutually exclusive projects with unequal lives, using either the least common
multiple of lives approach or the equivalent annual annuity approach, and 2)
capital rationing. (page 212)
d. explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation
can be used to assess the stand-alone risk of a capital project. (page 216)
e. explain and calculate the discount rate, based on market risk methods, to use in
valuing a capital project. (page 219)
f. describe types of real options and evaluate a capital project using real options.
(page 222)
g. describe common capital budgeting pitfalls. (page 225)
h. calculate and interpret accounting income and economic income in the context of
capital budgeting. (page 226)
i. distinguish among the economic profit, residual income, and claims valuation
models for capital budgeting and evaluate a capital project using each. (page 230)
The topical coverage corresponds with the following CFA Institute assigned reading:
21. Capital Structure
The candidate should be able to:
a. explain the Modigliani–Miller propositions regarding capital structure, including
the effects of leverage, taxes, financial distress, agency costs, and asymmetric
information on a company’s cost of equity, cost of capital, and optimal capital
structure. (page 246)
b. describe target capital structure and explain why a company’s actual capital
structure may fluctuate around its target. (page 254)
c. describe the role of debt ratings in capital structure policy. (page 254)
d. explain factors an analyst should consider in evaluating the effect of capital
structure policy on valuation. (page 255)
e. describe international differences in the use of financial leverage, factors that
explain these differences, and implications of these differences for investment
analysis. (page 255)
The topical coverage corresponds with the following CFA Institute assigned reading:
22. Dividends and Share Repurchases: Analysis
The candidate should be able to:
a. describe the expected effect of regular cash dividends, extra dividends, liquidating
dividends, stock dividends, stock splits, and reverse stock splits on shareholders’
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wealth and a company’s financial ratios. (page 265)
b. compare theories of dividend policy and explain implications of each for share
value given a description of a corporate dividend action. (page 267)
c. describe types of information (signals) that dividend initiations, increases,
decreases, and omissions may convey. (page 268)
d. explain how clientele effects and agency costs may affect a company’s payout
policy. (page 269)
e. explain factors that affect dividend policy in practice. (page 271)
f. calculate and interpret the effective tax rate on a given currency unit of corporate
earnings under double taxation, dividend imputation, and split-rate tax systems.
(page 272)
g. compare stable dividend, constant dividend payout ratio, and residual dividend
payout policies, and calculate the dividend under each policy. (page 276)
h. compare share repurchase methods. (page 278)
i. calculate and compare the effect of a share repurchase on earnings per share when
1) the repurchase is financed with the company’s surplus cash and
2) the company uses debt to finance the repurchase. (page 279)
j. calculate the effect of a share repurchase on book value per share. (page 280)
k. explain the choice between paying cash dividends and repurchasing shares. (page
281)
l. describe broad trends in corporate payout policies. (page 284)
m. calculate and interpret dividend coverage ratios based on 1) net income and 2) free
cash flow. (page 285)
n. identify characteristics of companies that may not be able to sustain their cash
dividend. (page 285)
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STUDY SESSION 8
The topical coverage corresponds with the following CFA Institute assigned reading:
23. Corporate Performance, Governance, and Business Ethics
The candidate should be able to:
a. compare interests of key stakeholder groups and explain the purpose of a
stakeholder impact analysis. (page 297)
b. discuss problems that can arise in principal–agent relationships and mechanisms
that may mitigate such problems. (page 300)
c. discuss roots of unethical behavior and how managers might ensure that ethical
issues are considered in business decision making. (page 301)
d. compare the Friedman doctrine, Utilitarianism, Kantian Ethics, and Rights and
Justice Theories as approaches to ethical decision making. (page 302)
The topical coverage corresponds with the following CFA Institute assigned reading:
24. Corporate Governance
The candidate should be able to:
a. describe objectives and core attributes of an effective corporate governance system
and evaluate whether a company’s corporate governance has those attributes.
(page 310)
b. compare major business forms and describe the conflicts of interest associated with
each. (page 310)
c. explain conflicts that arise in agency relationships, including manager–shareholder
conflicts and director–shareholder conflicts. (page 312)
d. describe responsibilities of the board of directors and explain qualifications and
core competencies that an investment analyst should look for in the board of
directors. (page 313)
e. explain effective corporate governance practice as it relates to the board of
directors and evaluate strengths and weaknesses of a company’s corporate
governance practice. (page 313)
f. describe elements of a company’s statement of corporate governance policies that
investment analysts should assess. (page 316)
g. describe environmental, social, and governance risk exposures. (page 317)
h. explain the valuation implications of corporate governance. (page 318)
The topical coverage corresponds with the following CFA Institute assigned reading:
25. Mergers and Acquisitions
The candidate should be able to:
a. classify merger and acquisition (M&A) activities based on forms of integration and
relatedness of business activities. (page 330)
b. explain common motivations behind M&A activity. (page 331)
c. explain bootstrapping of earnings per share (EPS) and calculate a company’s postmerger EPS. (page 333)
d. explain, based on industry life cycles, the relation between merger motivations and
types of mergers. (page 335)
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e. contrast merger transaction characteristics by form of acquisition, method of
payment, and attitude of target management. (page 337)
f. distinguish among pre-offer and post-offer takeover defense mechanisms. (page
340)
g. calculate and interpret the Herfindahl–Hirschman Index and evaluate the
likelihood of an antitrust challenge for a given business combination. (page 343)
h. compare the discounted cash flow, comparable company, and comparable
transaction analyses for valuing a target company, including the advantages and
disadvantages of each. (page 356)
i. calculate free cash flows for a target company and estimate the company’s intrinsic
value based on discounted cash flow analysis. (page 345)
j. estimate the value of a target company using comparable company and comparable
transaction analyses. (page 350)
k. evaluate a takeover bid and calculate the estimated post-acquisition value of an
acquirer and the gains accrued to the target shareholders versus the acquirer
shareholders. (page 360)
l. explain how price and payment method affect the distribution of risks and benefits
in M&A transactions. (page 364)
m. describe characteristics of M&A transactions that create value. (page 365)
n. distinguish among equity carve-outs, spin-offs, split-offs, and liquidation. (page
366)
o. explain common reasons for restructuring. (page 366)
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The following is a review of the Financial Reporting and Analysis (1) principles designed to address the
learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned
Reading #14.
READING 14: INTERCORPORATE
INVESTMENTS
Study Session 5
EXAM FOCUS
There are no shortcuts here. Spend the time necessary to learn how and when to use
each method of accounting for intercorporate investments because the probability of this
material being tested is high. Be able to determine the effects of each method on the
financial statements and ratios. Pay particular attention to the examples illustrating the
difference between the equity method and the acquisition method.
MODULE 14.1: CLASSIFICATIONS
CATEGORIES OF INTERCORPORATE
INVESTMENTS
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LOS 14.a: Describe the classification, measurement, and disclosure under
International Financial Reporting Standards (IFRS) for 1) investments in financial
assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and
5) special purpose and variable interest entities.
LOS 14.b: Distinguish between IFRS and US GAAP in the classification,
measurement, and disclosure of investments in financial assets, investments in
associates, joint ventures, business combinations, and special purpose and variable
interest entities.
CFA® Program Curriculum, Volume 2, page 10
Intercorporate investments in marketable securities are categorized as either (1)
investments in financial assets (when the investing firm has no significant control over
the operations of the investee firm), (2) investments in associates (when the investing
firm has significant influence over the operations of the investee firm, but not control),
or (3) business combinations (when the investing firm has control over the operations of
the investee firm).
Percentage of ownership (or voting control) is typically used to determine the
appropriate category for financial reporting purposes. However, the ownership
percentage is only a guideline. Ultimately, the category is based on the investor’s ability
to influence or control the investee.
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Investments in financial assets. An ownership interest of less than 20% is usually
considered a passive investment. In this case, the investor cannot significantly influence
or control the investee.
IFRS currently (current standards) classifies investments in financial assets as held-tomaturity, available-for-sale, or fair value through profit or loss (which includes held-fortrading and securities designated at fair value). Under U.S. GAAP, the accounting
treatment for investment in financial assets is similar to current IFRS. IFRS 9 (the new
standards) is applicable for annual periods beginning January 1, 2018, (early adoption is
allowed). Similarly, FASB issued ASC 825 in January 2016, which is applicable for
periods after December 15, 2017.
Investments in associates. An ownership interest between 20% and 50% is typically a
noncontrolling investment; however, the investor can usually significantly influence the
investee’s business operations. Significant influence can be evidenced by the following:
Board of directors representation.
Involvement in policy making.
Material intercompany transactions.
Interchange of managerial personnel.
Dependence on technology.
It may be possible to have significant influence with less than 20% ownership. In this
case, the investment is considered an investment in associates. Conversely, without
significant influence, an ownership interest between 20% and 50% is considered an
investment in financial assets.
The equity method is used to account for investments in associates.
Business combinations. An ownership interest of more than 50% is usually a
controlling investment. When the investor can control the investee, the acquisition
method is used.
It is possible to own more than 50% of an investee and not have control. For example,
control can be temporary or barriers may exist such as bankruptcy or governmental
intervention. In these cases, the investment is not considered controlling.
Conversely, it is possible to control with less than a 50% ownership interest. In this
case, the investment is still considered a business combination.
Joint ventures. A joint venture is an entity whereby control is shared by two or more
investors. Both IFRS and U.S. GAAP require the equity method for joint ventures. In
rare cases, IFRS and U.S. GAAP allow proportionate consolidation as opposed to the
equity method.
Figure 14.1 summarizes the accounting treatment for investments.
Figure 14.1: Accounting for Investments
Ownership
Degree of
Influence
Accounting Treatment
Less than 20%
(investments in financial
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assets)
20%–50%
(investment in associates)
More than 50%
(business combinations)
No significant
influence
Held-to-maturity, available-for-sale, fair value through
profit or loss.*
Significant
influence
Equity method
Control
Acquisition method
*Under the current standards
MODULE QUIZ 14.1
To best evaluate your performance, enter your quiz answers online.
1. Tall Company owns 30% of the common equity of Short Incorporated. Tall has
been unsuccessful in its attempts to obtain representation on Short’s board of
directors. For financial reporting purposes, Tall’s ownership interest is most likely
considered a(n):
A. investment in financial assets.
B. investment in associates.
C. business combination.
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MODULE 14.2: FINANCIAL ASSETS, PART 1
REPORTING OF INTERCORPORATE
INVESTMENTS (PRIOR TO ISSUANCE OF IFRS
9)
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Financial Assets
Investment ownership of less than 20% is usually considered passive. The acquisition of
financial assets is recorded at cost (presumably the fair value at acquisition), and any
dividend or interest income is recognized in the investor’s income statement.
Recognizing the change in the fair value of financial assets depends on their
classification as either held-to-maturity, held-for-trading, or available-for-sale. Firms
can also designate financial assets and financial liabilities at fair value.
1. Held-to-maturity. Held-to-maturity securities are debt securities acquired with
the intent and ability to be held-to-maturity. The securities cannot be sold prior to
maturity except in unusual circumstances.
Long-term held-to-maturity securities are reported on the balance sheet at
amortized cost. Amortized cost is the original cost of the debt security plus any
discount, or minus any premium, that has been amortized to date.
PROFESSOR’S NOTE
Amortized cost is simply the present value of the remaining cash flows (coupon payments
and face amount) discounted at the market rate of interest at issuance.
Interest income (coupon cash flow adjusted for amortization of premium or
discount) is recognized in the income statement but subsequent changes in fair
value are ignored.
2. Fair value through profit or loss (held-for-trading or designated at fair value)
a. Held-for-trading. Held-for-trading securities are debt and equity securities
acquired for the purposes of profiting in the near term, usually less than
three months. Held-for-trading securities are reported on the balance sheet at
fair value. The changes in fair value, both realized and unrealized, are
recognized in the income statement along with any dividend or interest
income.
b. Designated at fair value. Firms can choose to report debt and
equitysecurities that would otherwise be treated as held-to-maturity or
available-for-sale securities at fair value. Designating financial assets and
liabilities at fair value can reduce volatility and inconsistencies that result
from measuring assets and liabilities using different valuation bases.
Unrealized gains and losses on designated financial assets and liabilities are
recognized on the income statement, similar to the treatment of held-fortrading securities.
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3. Available-for-sale. Available-for-sale securities are debt and equity securities that
are neither held-to-maturity nor held-for-trading. Like held-for-trading securities,
available-for-sale securities are reported on the balance sheet at fair value.
However, only the realized gains or losses, and the dividend or interest income,
are recognized in the income statement. The unrealized gains and losses (net of
taxes) are excluded from the income statement and are reported as a separate
component of stockholders’ equity (in other comprehensive income). When the
securities are sold, the unrealized gains and losses are removed from other
comprehensive income, as they are now realized, and recognized in the income
statement.
The treatment under IFRS is similar to U.S. GAAP, except for unrealized gains or
losses that result from foreign exchange movements. Foreign exchange gains and losses
on available-for-sale debt securities are recognized in the income statement under IFRS.
The entire unrealized gain or loss is recognized in equity under U.S. GAAP. For
available for-sale equity securities, the treatment under IFRS is similar to the treatment
under U.S. GAAP.
Let’s look at an example of the different classifications for financial assets.
EXAMPLE: Investment in financial assets
At the beginning of the year, Midland Corporation purchased a 9% bond with a face value of
$100,000 for $96,209 to yield 10%. The coupon payments are made annually at year-end. Let’s
suppose the fair value of the bond at the end of the year is $98,500.
Determine the impact on Midland’s balance sheet and income statement if the bond investment is
classified as held-to-maturity, held-for-trading (or fair value through profit or loss), and availablefor-sale.
Answer:
Held-to-maturity: The balance sheet value is based on amortized cost. At year-end, Midland
recognizes interest revenue of $9,621 ($96,209 beginning bond investment × 10% market rate at
issuance). The interest revenue includes the coupon payment of $9,000 ($100,000 face value × 9%
coupon rate) and the amortized discount of $621 ($9,621 interest revenue − $9,000 coupon
payment).
At year-end, the bond is reported on the balance sheet at $96,830 ($96,209 beginning bond
investment + $621 amortized discount).
Held-for-trading: The balance sheet value is based on fair value of $98,500. Interest revenue of
$9,621 ($96,209 beginning bond investment × 10% yield-to-maturity at issuance) and an unrealized
gain of $1,670 ($98,500 − $96,209 − $621) are recognized in the income statement.
Available-for-sale: The balance sheet value is based on fair value of $98,500. Interest revenue of
$9,621 ($96,209 beginning bond investment × 10% yield-to-maturity at issuance) is recognized in
the income statement. The unrealized gain of $1,670 ($98,500 − $96,209 − $621) is reported in
stockholders’ equity as a component of other comprehensive income.
Now let’s imagine that the bonds are called on the first day of the next year for $101,000. Calculate
the gain or loss recognition for each classification.
Held-to-maturity: A realized gain of $4,170 ($101,000 − $96,830 carrying value) is recognized in
the income statement.
Held-for-trading: A net gain of $2,500 ($101,000 − $98,500 carrying value) is recognized in the
income statement.
Available-for-sale: The unrealized gain of $1,670 is removed from equity, and a realized gain of
$4,170 ($101,000 − $96,830) is recognized in the income statement.
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Figure 14.2 summarizes the effects of the different classifications for financial assets on
the balance sheet and income statement.
Figure 14.2: Summary of Classifications of Financial Assets
Held-to-Maturity
Fair Value Through
Profit or Loss
Available-for-Sale
Amortized cost
Fair value
Fair value with unrealized G/L
recognized in equity
Balance
sheet
Interest
Interest
Interest (including
amortization)
Income
statement
Dividends
Dividends
Realized G/L
Realized G/L*
Realized G/L
Unrealized G/L
* G/L = Gain and losses.
MODULE QUIZ 14.2
To best evaluate your performance, enter your quiz answers online.
Use the following information to answer Questions 1 through 5.
Kirk Company acquired shares in the equity of both Company A and Company B. We
have the following information from the public market about Company A and
Company B’s investment value at the time of purchase and at two subsequent dates:
Security
Cost
t=1
t=2
A
$950
$850
$900
B
250
180
350
1. Kirk Company will report the initial value of its investment in financial assets as:
A. $1,030.
B. $1,200.
C. $1,250.
2. At t = 1, Kirk will:
A. carry the financial assets at cost.
B. write down the financial assets to $1,030 and recognize an unrealized loss
of $170.
C. write down the financial assets to $1,030 and recognize a realized loss of
$170.
3. At t = 2, Kirk will report the carrying value of its financial assets as:
A. $1,030.
B. $1,200.
C. $1,250.
4. Based on the information provided, which of the following statements is most
accurate?
A. Classifying the shares as trading securities would result in greater reported
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A. Classifying the shares as trading securities would result in greater reported
earnings volatility for Kirk.
B. Classifying the shares as available-for-sale securities would result in a $220
realized gain for Kirk between t = 1 and t = 2.
C. It is optimal for Kirk to classify its shares in Company A and Company B as
available-for-sale securities since it results in a net $50 gain recognized on
the income statement at t = 2.
5. Suppose for this question only that Security A and Security B are both debt
securities held-to-maturity and purchased initially at par. At t = 2, Kirk will report
the carrying value of these securities as:
A. $1,030.
B. $1,200.
C. $1,250.
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MODULE 14.3: FINANCIAL ASSETS, PART 2—
IMPAIRMENTS, RECLASSIFICATIONS
Reclassification of Investments in
Financial Assets
covering
IFRS typically does not allow reclassification of investments into or out Video
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of the designated at fair value category. Reclassification of investments available online.
out of the held-for-trading category is severely restricted under IFRS.
Debt securities classified as available-for-sale can be reclassified as held-to-maturity if
the holder intends to (and is able to) hold the debt to its maturity date. The security’s
balance sheet value is remeasured to reflect its fair value at the time it is reclassified.
Any difference between this amount and the maturity value, and nany gain or loss that
had been recorded in other comprehensive income, is amortized over the security’s
remaining life.
Held-to-maturity securities can be reclassified as available-for-sale if the holder no
longer intends or is no longer able to hold the debt to maturity. The carrying value is
remeasured to the security’s fair value, with any difference recognized in other
comprehensive income. Note that reclassifying a held-to-maturity security may prevent
the holder from classifying other debt securities as held-to-maturity, or even require
other held-to-maturity debt to be reclassified as available-for-sale.
U.S. GAAP does permit securities to be reclassified into or out of held-for-trading or
designated at fair value. Unrealized gains are recognized on the income statement at the
time the security is reclassified. For investments transferring out of available-for-sale
category into held-for-trading category, the cumulative amount of gains and losses
previously recorded under other comprehensive income is recognized in income. For a
debt security transferring out of the available-for-sale category into the held-to-maturity
category, the cumulative amount of gains and losses previously recorded under other
comprehensive income is amortized over the remaining life of the security. For
transferring investments into the available-for-sale category from the held-to-maturity
category, the unrealized gain/loss is transferred to comprehensive income. Figure 14.3
summarizes the rules of reclassification.
Figure 14.3: Reclassification of Financial Assets
From
To
Unrealized Gain or Loss
Any
Income Statement (to extent not
recognized)
Held-to-maturity
Fair value through profit or
loss*
Income Statement
Held-to-maturity
Available-for-sale
Other comprehensive income
Available-for-sale
Held-to-maturity
Amortize out of other comprehensive
income
Fair value through profit or
loss*
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Available-for-sale
Fair value through profit or
loss*
Transfer out of other comprehensive
income
*Restricted under IFRS
All transfers occur at fair value as of the transfer date.
Impairment of Financial Assets
If the value that can be recovered for a financial asset is less than its carrying value and
is expected to remain so, the financial asset is impaired. IFRS and U.S. GAAP require
that held-to-maturity (HTM) and available-for-sale (AFS) securities be evaluated for
impairment at each reporting period. This is not necessary for held-for-trading and
designated at fair value securities because declines in their values are recognized on the
income statement as they occur.
U.S. GAAP
Under U.S. GAAP, a security is considered impaired if its decline in value is
determined to be other than temporary. For both HTM and AFS securities, the writedown to fair value is treated as a realized loss (i.e., recognized on the income
statement).
U.S. GAAP—Reversals
A subsequent reversal of impairment losses is not allowed.
IFRS
As under U.S. GAAP, impairments under IFRS are recognized in the income statement.
Impairment of a debt or equity security is indicated if at least one loss event has
occurred, and its effect on the security’s future cash flows can be estimated reliably.
Losses due to occurrences of future events (regardless of the probability of occurrence)
are not recognized.
For debt securities, loss events can include default on payments of interest or principal,
likely bankruptcy or reorganization of the issuer, concessions from the bondholders, or
other indications of financial difficulty on the part of the issuer. However, a credit rating
downgrade or the lack of a liquid market for the debt are not considered to be
indications of impairment in the absence of other evidence.
For equities, a loss event has occurred if the fair value of the security has experienced a
substantial or extended decline below its carrying value or if changes in the business
environment facing the equity issuer (such as economic, legal, or technological
developments) have made it unlikely that the value of the equity will recover to its
initial cost.
If a held-to-maturity security has become impaired, its carrying value is decreased to the
present value of its estimated future cash flows, using the same effective interest rate
that was used when the security was purchased. This may not be equal to its fair value.
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IFRS—Reversals
If the held-to-maturity security’s value recovers in a later period, and its recovery can be
attributed to an event (such as a credit upgrade), the impairment loss can be reversed.
Impairments of available-for-sale debt securities may be reversed under the same
conditions as impairments of held-to-maturity securities. Reversals of impairments are
not permitted for equity securities.
Analysis of Investments in Financial Assets
When analyzing a firm with investments in financial assets, it is important to separate
the firm’s operating results from its investment results (e.g., interest, dividends, and
gains and losses).
For comparison purposes, using market values for financial assets is generally preferred.
Also, it is necessary to remove nonoperating assets when calculating the return on
operating assets ratio.
Finally, the analyst must assess the effects of investment classification on reported
performance. Investment results may be misleading because of inconsistent treatment of
unrealized gains and losses. For example, if security prices are increasing, an investor
that classifies an investment as held-for-trading will report higher earnings than if the
investment is classified as available-for-sale. This is because the unrealized gains are
recognized in the income statement for a held-for-trading security. The unrealized gains
are reported in stockholders’ equity for an available-for-sale security.
IFRS 9 New Standards for 2018
These new standards became effective for periods starting January 1, 2018.
IFRS 9 does away with the terms held-for-trading, available-for-sale, and held-tomaturity. Instead, the three classifications are amortized cost, fair value through
profit or loss (FVPL), and fair value through other comprehensive income (FVOCI).
Amortized Cost (for Debt Securities Only)
Debt securities that meet two criteria are accounted for using the amortized cost method
(which is the same as the held-to-maturity method discussed before).
Criteria for amortized cost accounting:
1. Business model test: Debt securities are being held to collect contractual cash
flows.
2. Cash flow characteristic test: The contractual cash flows are either principal, or
interest on principal, only.
Fair Value Through Profit or Loss (for Debt and Equity
Securities)
Debt securities may be classified as fair value through profit or loss (FVPL) if held for
trading, or if accounting for those securities at amortized cost results in an accounting
mismatch. Equity securities that are held for trading must be classified as FVPL. Other
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equity securities may be classified as either fair value through profit or loss, or fair
value through OCI. Once classified, the choice is irrevocable. Derivatives that are not
used for hedging are always carried at FVPL. If an asset has an embedded derivative
(e.g., convertible bonds), the asset as a whole is valued at FVPL.
Fair Value Through OCI (for Debt and Equity Securities)
The accounting treatment under fair value through OCI is the same as under the
previously used available-for-sale classification.
Reclassification Under IFRS 9
Reclassification of equity securities under the new standards is not permitted as the
initial designation (FVPL or FVOCI) is irrevocable. Reclassification of debt securities is
permitted only if the business model has changed. For example, unrecognized
gains/losses on debt securities carried at amortized cost and reclassified as FVPL are
recognized in the income statement. Debt securities that are reclassified out of FVPL as
measured at amortized cost are transferred at fair value on the transfer date, and that fair
value will become the carrying amount.
Loan Impairment Under IFRS 9
A key feature of IFRS 9 was that the incurred loss model for loan impairment was
replaced by the expected credit loss model. This requires companies to not only evaluate
current and historical information about loan (including loan commitments and lease
receivables) performance, but to also use forward-looking information. The new criteria
results in an earlier recognition of impairment (12-month expected losses for
performing loans and lifetime expected losses for nonperforming loans).
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MODULE 14.4: INVESTMENT IN ASSOCIATES, PART 1—
EQUITY METHOD
Investments in Associates
Investment ownership of between 20% and 50% is usually considered
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influential. Influential investments are accounted for using the equity
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method. Under the equity method, the initial investment is recorded at available
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cost and reported on the balance sheet as a noncurrent asset.
In subsequent periods, the proportionate share of the investee’s earnings increases the
investment account on the investor’s balance sheet and is recognized in the investor’s
income statement. Dividends received from the investee are treated as a return of capital
and thus, reduce the investment account. Unlike investments in financial assets,
dividends received from the investee are not recognized in the investor’s income
statement.
If the investee reports a loss, the investor’s proportionate share of the loss reduces the
investment account and also lowers earnings in the investor’s income statement. If the
investee’s losses reduce the investment account to zero, the investor usually
discontinues use of the equity method. The equity method is resumed once the
proportionate share of the investee’s earnings exceed the share of losses that were not
recognized during the suspension period.
Fair Value Option
U.S. GAAP allows equity method investments to be recorded at fair value. Under IFRS,
the fair value option is only available to venture capital firms, mutual funds, and similar
entities. The decision to use the fair value option is irrevocable and any changes in value
(along with dividends) are recorded in the income statement.
EXAMPLE: Implementing the equity method
Suppose that we are given the following:
December 31, 20X5, Company P (the investor) invests $1,000 in return for 30% of the
common shares of Company S (the investee).
During 20X6, Company S earns $400 and pays dividends of $100.
During 20X7, Company S earns $600 and pays dividends of $150.
Calculate the effects of the investment on Company P’s balance sheet, reported income, and cash
flow for 20X6 and 20X7.
Answer:
Using the equity method for 20X6, Company P will:
Recognize $120 ($400 × 30%) in the income statement from its proportionate share of the net
income of Company S.
Increase its investment account on the balance sheet by $120 to $1,120, reflecting its
proportionate share of the net assets of Company S.
Receive $30 ($100 × 30%) in cash dividends from Company S and reduce its investment in
Company S by that amount to reflect the decline in the net assets of Company S due to the
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dividend payment.
At the end of 20X6, the carrying value of Company S on Company P’s balance sheet will be $1,090
($1,000 original investment + $120 proportionate share of Company S net income − $30 dividend
received).
For 20X7, Company P will recognize income of $180 ($600 × 30%) and increase the investment
account by $180. Also, Company P will receive dividends of $45 ($150 × 30%) and lower the
investment account by $45. Hence, at the end of 20X7, the carrying value of Company S on
Company P’s balance sheet will be $1,225 ($1,090 beginning balance + $180 proportionate share
of Company S net income − $45 dividend received).
Excess of Purchase Price Over Book Value Acquired
Rarely does the price paid for an investment equal the proportionate book value of the
investee’s net assets, since the book value of many assets and liabilities is based on
historical cost.
At the acquisition date, the excess of the purchase price over the proportionate share of
the investee’s book value is allocated to the investee’s identifiable assets and liabilities
based on their fair values. Any remainder is considered goodwill.
In subsequent periods, the investor recognizes expense based on the excess amounts
assigned to the investee’s assets and liabilities. The expense is recognized consistent
with the investee’s recognition of expense. For example, the investor might recognize
additional depreciation expense as a result of the fair value allocation of the purchase
price to the investee’s fixed assets.
It is important to note that the purchase price allocation to the investee’s assets and
liabilities is included in the investor’s balance sheet, not the investee’s. In addition, the
additional expense that results from the assigned amounts is not recognized in the
investee’s income statement. Under the equity method of accounting, the investor must
adjust its balance sheet investment account and the proportionate share of the income
reported from the investee for this additional expense.
PROFESSOR’S NOTE
Under the equity method, the investor does not actually report the separate assets and
liabilities of the investee. Rather, the investor reports the investment in one line on its
balance sheet. This one-line investment account includes the proportionate share of the
investee’s net assets at fair value and the goodwill.
EXAMPLE: Allocation of purchase price over book value acquired
At the beginning of the year, Red Company purchased 30% of Blue Company for $80,000. On the
acquisition date, the book value of Blue’s identifiable net assets was $200,000. Also, the fair value
and book value of Blue’s assets and liabilities were the same except for Blue’s equipment, which
had a book value of $25,000 and a fair value of $75,000 on the acquisition date. Blue’s equipment
is depreciated over ten years using the straight-line method. At the end of the year, Blue reported
net income of $100,000 and paid dividends of $60,000.
Part A: Calculate the goodwill created as a result of the purchase.
Part B: Calculate Red’s income at the end of the year from its investment in Blue.
Part C: Calculate the investment in Blue that appears on Red’s year-end balance sheet.
Answer:
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Part A
The excess of purchase price over the proportionate share of Blue’s book value is allocated to the
equipment. The remainder is goodwill.
Part B
Red recognizes its proportionate share of Blue’s net income for the year. Also, Red must recognize
the additional depreciation expense that resulted from the purchase price allocation.
Part C
The beginning balance of Red’s investment account is increased by the equity income from Blue
and is decreased by the dividends received from Blue.
PROFESSOR’S NOTE
An alternative method of calculating the year-end investment is as follows:
% acquired × (book value of net assets at beginning of year + net income − dividends) +
unamortized excess purchase price
= [0.3 × (200,000 + 100,000 − 60,000)] + (20,000 − 1,500) = $90,500
MODULE QUIZ 14.3, 14.4
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1. If a company uses the equity method to account for an investment in another
company:
A. income is combined to the extent of ownership.
B. all income of the affiliate is included except intercompany transfers.
C. earnings of the affiliate are included but reduced by any dividends paid to
the company.
Use the following information to answer Questions 2 through 4.
Suppose Company P acquired 40% of the shares of Company A for
$1.5 million on January 1, 2016. During the year, Company A earned $500,000 and
paid dividends of $125,000.
2. At the end of 2016, Company P reported investment in Company A as:
A. $1.5 million.
B. $1.65 million.
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C. $1.7 million.
3. For 2016, Company P reported investment income of:
A. $50,000.
B. $150,000.
C. $200,000.
4. For 2016, Company P received cash flow from the investee of:
A. $50,000.
B. $150,000.
C. $200,000.
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MODULE 14.5: INVESTMENT IN ASSOCIATES, PART 2
Impairments of Investments in Associates
Equity method investments must be tested for impairment. Under U.S.
GAAP, if the fair value of the investment falls below the carrying value Video covering
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(investment account on the balance sheet) and the decline is considered available
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other-than-temporary, the investment is written-down to fair value and a
loss is recognized on the income statement. Under IFRS, impairment
needs to be evidenced by one or more loss events. Under both IFRS and U.S. GAAP, if
there is a recovery in value in the future, the asset cannot be written-up.
Transactions With the Investee
So far, our discussion has ignored transactions between the investor and investee.
Because of its ownership interest, the investor may be able to influence transactions
with the investee. Thus, profit from these transactions must be deferred until the profit is
confirmed through use or sale to a third party.
Transactions can be described as upstream (investee to the investor) or downstream
(investor to the investee). In an upstream sale, the investee has recognized all of the
profit in its income statement. However, for profit that is unconfirmed (goods have not
been used or sold by the investor), the investor must eliminate its proportionate share of
the profit from the equity income of the investee.
For example, suppose that Investor owns 30% of Investee. During the year, Investee
sold goods to Investor and recognized $15,000 of profit from the sale. At year-end, half
of the goods purchased from Investee remained in Investor’s inventory.
All of the profit is included in Investee’s net income. Investor must reduce its equity
income of Investee by Investor’s proportionate share of the unconfirmed profit. Since
half of the goods remain, half of the profit is unconfirmed. Thus, Investor must reduce
its equity income by $2,250 [($15,000 total profit × 50% unconfirmed) × 30%
ownership interest]. Once the inventory is sold by Investor, $2,250 of equity income
will be recognized.
In a downstream sale, the investor has recognized all of the profit in its income
statement. Like the upstream sale, the investor must eliminate the proportionate share of
the profit that is unconfirmed.
For example, imagine again that Investor owns 30% of Investee. During the year,
Investor sold $40,000 of goods to Investee for $50,000. Investee sold 90% of the goods
by year-end.
In this case, Investor’s profit is $10,000 ($50,000 sales – $40,000 COGS). Investee has
sold 90% of the goods; thus, 10% of the profit remains in Investee’s inventory. Investor
must reduce its equity income by the proportionate share of the unconfirmed profit:
$10,000 profit × 10% unconfirmed amount × 30% ownership interest = $300. Once
Investee sells the remaining inventory, Investor can recognize $300 of profit.
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Analytical Issues for Investments in Associates
When an investee is profitable, and its dividend payout ratio is less than 100%, the
equity method usually results in higher earnings as compared to the accounting methods
used for minority passive investments. Thus, the analyst should consider if the equity
method is appropriate for the investor. For example, an investor could use the equity
method in order to report the proportionate share of the investee’s earnings, when it
cannot actually influence the investee.
Also, the investee’s individual assets and liabilities are not reported on the investor’s
balance sheet. The investor simply reports its proportionate share of the investee’s
equity in one line on the balance sheet. By ignoring the investee’s debt, leverage is
lower. In addition, the margin ratios are higher since the investee’s revenues are
ignored.
Finally, the proportionate share of the investee’s earnings is recognized in the investor’s
income statement, but the earnings may not be available to the investor in the form of
cash flow (dividends). That is, the investee’s earnings may be permanently reinvested.
Under the acquisition method, all of the assets, liabilities, revenues, and expenses of the
subsidiary are combined with the parent. Intercompany transactions are excluded.
In the case where the parent owns less than 100% of the subsidiary, it is necessary to
create a noncontrolling (minority) interest account for the proportionate share of the
subsidiary’s net assets that are not owned by the parent.
MODULE 14.6: BUSINESS COMBINATIONS:
BALANCE SHEET
Business Combinations
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Under IFRS, business combinations are not differentiated based on the structure of the
surviving entity. Under U.S. GAAP, business combinations are categorized as:
Merger. The acquiring firm absorbs all the assets and liabilities of the acquired
firm, which ceases to exist. The acquiring firm is the surviving entity.
Acquisition. Both entities continue to exist in a parent-subsidiary relationship.
Recall that when less than 100% of the subsidiary is owned by the parent, the
parent prepares consolidated financial statements but reports the unowned
(minority or noncontrolling) interest on its financial statements.
Consolidation. A new entity is formed that absorbs both of the combining
companies.
Historically, two accounting methods have been used for business combinations:
(1) the purchase method and (2) the pooling-of-interests method. However, the pooling
method has been eliminated from U.S. GAAP and IFRS. Now, the acquisition method
(which replaces the purchase method) is required.
The pooling-of-interests method, also known as uniting-of-interests method under
IFRS, combined the ownership interests of the two firms and viewed the participants as
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equals—neither firm acquired the other. The assets and liabilities of the two firms were
simply combined. Key attributes of the pooling method include the following:
The two firms are combined using historical book values.
Operating results for prior periods are restated as though the two firms were
always combined.
Ownership interests continue, and former accounting bases are maintained.
Note that fair values played no role in accounting for a business combination using the
pooling method—the actual price paid was suppressed from the balance sheet and
income statement. Analysts should be aware that transactions reported under the pooling
(uniting-of-interests) method prior to 2001 (2004) may still be reported under that
method.
Let’s look at an example of the acquisition method.
Suppose that on January 1, 2010, Company P acquires 80% of the common stock of
Company S by paying $8,000 in cash to the shareholders of Company S. The
preacquisition balance sheets of Company P and Company S are shown in Figure 14.4.
Figure 14.4: Preacquisition Balance Sheets
Preacquisition Balance Sheets
Company P
Company S
Current assets
$48,000
$16,000
Other assets
32,000
8,000
Total
$80,000
$24,000
Current liabilities
$40,000
$14,000
Common stock
28,000
6,000
Retained earnings
12,000
4,000
Total
$80,000
$24,000
January 1, 2010
Under the equity method of accounting, Company P will report its 80% interest in
Company S in a one-line investment account on the balance sheet.
In an acquisition, the assets and liabilities of Company P and Company S are combined,
and the stockholders’ equity of Company S is ignored. It is also necessary to create a
minority interest account for the portion of Company S’s equity that is not owned by
Company P. Figure 14.5 compares the acquisition method and the equity method on
Company P’s post-acquisition balance sheet.
Figure 14.5: Balance Sheet Comparison of the Acquisition and Equity Methods
Company P Post-Acquisition Balance Sheet
Acquisition Method
Equity Method
$56,000
$40,000
January 1, 2010
Current assets
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Current assets
$56,000
$40,000
Investment in S
8,000
Other assets
40,000
32,000
Total
$96,000
$80,000
Current liabilities
$54,000
$40,000
Minority interest
2,000
Common stock
28,000
28,000
Retained earnings
12,000
12,000
Total
$96,000
$80,000
Post-acquisition, Company P’s current assets are lower by the $8,000 cash used to
acquire 80% of Company S. Under the acquisition method, the current assets are
$56,000 ($48,000 P current assets + $16,000 S current assets − $8,000 cash). With the
equity method, current assets are $40,000 ($48,000 P current assets − $8,000 cash).
PROFESSOR’S NOTE
Where does the $8,000 go? It goes to the departing shareholders from whom the shares were
purchased.
When using the acquisition method, Company P reports 100% of Company S’s assets
and liabilities even though Company P only owns 80%. The remaining 20% of
Company S is owned by minority investors and the difference is accounted for using a
noncontrolling (minority) interest account. The minority interest is created by
multiplying the subsidiary’s equity by the percentage of the subsidiary not owned by the
parent. In our example, the minority interest is $2,000 ($10,000 S equity × 20%).
Noncontrolling interest is reported in stockholders’ equity.
MODULE QUIZ 14.5, 14.6
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Use the following information to answer Questions 1 though 3.
Suppose Company P acquires 80% of the common stock of Company S on December
31, 2016, by paying $120,000 cash to the shareholders of Company S. The two firms’
pre-acquisition balance sheets as of December 31, 2016, and pre-acquisition pro
forma income statements for the year ending December 31, 2017, follow:
Pre-Acquisition Balance Sheets
Company P
Company S
Current assets
$720,000
$240,000
Other assets
480,000
120,000
December 31, 2016
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Total assets
$1,200,000
$360,000
Current liabilities
$600,000
$210,000
Common stock
420,000
90,000
Retained earnings
180,000
60,000
$1,200,000
$360,000
Total liabilities & equity
Unconsolidated Income Statements
Company P
Company S
Revenue
$900,000
$300,000
Expenses
600,000
240,000
Net income
$300,000
$60,000
December 31, 2017
Dividends
$15,000
1. Immediately after the acquisition, Company P will report total assets of:
A. $1,080,000.
B. $1,440,000.
C. $1,560,000.
2. For the year ended December 31, 2017, Company P’s pro forma consolidated net
income is:
A. $300,000.
B. $348,000.
C. $360,000.
3. On its December 31, 2017, pro forma consolidated balance sheet, Company P
should report a minority ownership interest of:
A. $0.
B. $39,000.
C. $42,000.
MODULE 14.7: BUSINESS COMBINATIONS:
INCOME STATEMENT
Now let’s look at the income statements. Figure 14.6 contains the
separate income statements of Company P and Company S for the year
ended December 31, 2010.
Figure 14.6: Company P and S Income Statements
Income Statements
Company P
Company S
Year ended December 31, 2010
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Revenue
$60,000
$20,000
Expenses
40,000
16,000
Net income
$20,000
$4,000
Under the equity method, Company P will report its 80% share of Company S’s net
income in a one-line account in the income statement. Under the acquisition method, the
revenue and expenses of Company P and Company S are combined. It is also necessary
to create a minority interest in the income statement for the portion of Company S’s net
income that is not owned by Company P.
Figure 14.7 compares the income statement effects of the acquisition method and equity
method.
Figure 14.7: Income Statement Comparison of Acquisition and Equity Methods
Company P Income Statement
Acquisition Method
Equity Method
Revenue
$80,000
$60,000
Expenses
56,000
40,000
Operating income
$24,000
$20,000
Year ended December 31, 2010
Equity in income of S
3,200
Minority interest
(800)
Net income
$23,200
$23,200
Similar to the consolidated balance sheet, Company P reports 100% of Company S’s
revenues and expenses even though Company P only owns 80%. Thus, a minority
interest is created by multiplying the subsidiary’s net income by the percentage of the
subsidiary not owned. In our example, the minority interest is $800 ($4,000 S net
income × 20%). The minority interest is subtracted in arriving at consolidated net
income.
Notice the acquisition method results in higher revenues and expenses, as compared to
the equity method, but net income is the same.
PROFESSOR’S NOTE
This example assumed that the parent company acquired its interest in the subsidiary by
paying the proportionate share of the subsidiary’s book value. If the parent pays more than
its proportionate share of book value, the excess is allocated to tangible and intangible assets.
The minority interest computation in the example also would be different. This will be
covered later in this topic review.
MODULE QUIZ 14.7
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Use the following information to answer Questions 1 and 2.
Company M acquired 20% of Company N for $6 million on January 1, 2017. Company
N’s debt and equity securities are publicly traded on an organized exchange.
Company N reported the following for the year ended 2017:
Year
Net Income (Loss)
Dividends
2017
($450,000)
$600,000
1. If Company M can significantly influence Company N, what is the balance sheet
carrying value of Company M’s investment at the end of 2017?
A. $5,790,000.
B. $5,970,000.
C. $6,000,000.
2. If Company M can significantly influence Company N, what amount of income
should Company M recognize from its investment for the year ended 2017?
A. ($90,000).
B. ($210,000).
C. $30,000.
3. Selected operating results for Lowdown, Inc., in 2016 and 2017 are shown in the
following table:
Lowdown, Inc.
2016
2017
$1,000
$1,140
$45
$160
Total revenues
1,045
1,300
Operating costs
500
640
Pre-tax operating income
545
660
Sales and operating revenues
Investment income
Martha Patterson, an analyst with Cauldron Associates, has been assigned the
task of separating Lowdown’s operating and investment results. She intends to
do this by removing the effects of the returns on Lowdown’s marketable
securities portfolio and forecasting operating income for 2018. Patterson
assumes that growth trend in operating income from 2016 to 2017 will continue
in 2018.
The appropriate forecast of Lowdown’s operating income in 2018 based on
Patterson’s analysis is closest to:
A. $500.
B. $650.
C. $700.
MODULE 14.8: BUSINESS COMBINATIONS:
GOODWILL
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Under the acquisition method, the purchase price is allocated to the
identifiable assets and liabilities of the acquired firm on the basis of fair value. Any
remainder is reported on the balance sheet as goodwill. Goodwill is said to be an
unidentifiable asset that cannot be separated from the business.
Under U.S. GAAP, goodwill is the amount by which the fair value of the subsidiary is
greater than the fair value of the acquired company’s identifiable net assets (full
goodwill). Under IFRS, goodwill is the excess of the purchase price over the fair value
of the acquiring company’s proportion of the acquired company’s identifiable net assets
(partial goodwill). However, IFRS permits the use of the full goodwill approach also.
Full goodwill (required under U.S. GAAP; allowed under IFRS):
full goodwill = (fair value of equity of whole subsidiary) − (fair value of net
identifiable assets of the subsidiary)
Partial goodwill (only allowed under IFRS):
partial goodwill = purchase price − (% owned × FV of net identifiable assets of the
subsidiary)
or
partial goodwill = % owned × full goodwill
Let’s look at an example of calculating acquisition goodwill.
EXAMPLE: Goodwill
Wood Corporation paid $600 million for all of the outstanding stock of Pine Corporation. At the
acquisition date, Pine reported the condensed balance sheet below:
Pine Corporation Condensed Balance Sheet
The fair value of the plant and equipment was $120 million more than its recorded book value. The
fair values of all other identifiable assets and liabilities were equal to their recorded book values.
Calculate the amount of goodwill Wood should report in its consolidated balance sheet.
Answer:
Goodwill is equal to the excess of purchase price over the fair value of identifiable assets and
liabilities acquired. The plant and equipment was written-up by $120 million to reflect fair value.
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The goodwill reported on Pine’s balance sheet is an unidentifiable asset and is thus ignored in the
calculation of Wood’s goodwill.
EXAMPLE: Full goodwill vs. partial goodwill
Continuing the previous example, suppose that Wood paid $450 million for 75% of the stock of
Pine. Calculate the amount of goodwill Wood should report using the full goodwill method and the
partial goodwill method.
Answer:
Full goodwill method:
Wood’s balance sheet goodwill is the excess of the fair value of the subsidiary ($450 million / 0.75
= $600 million) over the fair value of identifiable net assets acquired, just as in the previous
example. Acquisition goodwill = $40 million.
Partial goodwill method:
Wood’s balance sheet goodwill is the excess of the acquisition price over Wood’s proportionate
share of the fair value of Pine’s identifiable net assets:
Goodwill is lower using the partial goodwill method. How is this reflected on the
liabilities-and-equity side of the balance sheet?
The value of noncontrolling interest also depends on which method is used. If the full
goodwill method is used, noncontrolling interest is based on the acquired company’s
fair value. If the partial goodwill method is used, noncontrolling interest is based on the
fair value of the acquired company’s identifiable net assets.
In the previous example, noncontrolling interest using the full goodwill method is 25%
of Wood’s fair value of $600 million, or $150 million. Using the partial goodwill
method, noncontrolling interest is 25% of the fair value of Pine’s identifiable net assets,
or $140 million. The difference of $10 million balances the $10 million difference in
goodwill.
The full goodwill method results in higher total assets and higher total equity than the
partial goodwill method. Thus, return on assets and return on equity will be lower if the
full goodwill method is used.
Goodwill is not amortized. Instead, it is tested for impairment at least annually.
Impairment occurs when the carrying value exceeds the fair value. However, measuring
the fair value of goodwill is complicated by the fact that goodwill cannot be separated
from the business. Because of its inseparability, goodwill is valued at the reporting unit
level.
Under IFRS, testing for impairment involves a single step approach. If the carrying
amount of the cash generating unit (where the goodwill is assigned) exceeds the
recoverable amount, an impairment loss is recognized.
Under U.S. GAAP, goodwill impairment potentially involves two steps. In the first step,
if the carrying value of the reporting unit (including the goodwill) exceeds the fair value
of the reporting unit, an impairment exists.
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Once it is determined the goodwill is impaired, the loss is measured as the difference
between the carrying value of the goodwill and the implied fair value of the goodwill.
The impairment loss is recognized in the income statement as a part of continuing
operations.
PROFESSOR’S NOTE
Notice that the impairment test for goodwill is based on the decline in value of the reporting
unit, while the loss is based on the decline in value of the goodwill.
The implied fair value of the goodwill is calculated in the same manner as goodwill at
the acquisition date. That is, the fair value of the reporting unit is allocated to the
identifiable assets and liabilities as if they were acquired on the impairment
measurement date. Any excess is considered the implied fair value of the goodwill.
Let’s look at an example.
EXAMPLE: Impaired goodwill
Last year, Parent Company acquired Sub Company for $1,000,000. On the date of acquisition, the
fair value of Sub’s net assets was $800,000. Thus, Parent reported acquisition goodwill of $200,000
($1,000,000 purchase price − $800,000 fair value of Sub’s net assets).
At the end of this year, the fair value of Sub is $950,000, and the fair value of Sub’s net assets is
$775,000. Assuming the carrying value of Sub is $980,000, determine if an impairment exists and
calculate the loss (if applicable) under U.S. GAAP and under IFRS.
Answer:
U.S. GAAP (two-step approach):
1. Since the carrying value of Sub exceeds the fair value of Sub ($980,000 carrying value >
$950,000 fair value), an impairment exists.
2. In order to measure the impairment loss, the implied goodwill must be compared to the
carrying value of the goodwill. At the impairment measurement date, the implied value of the
goodwill is $175,000 ($950,000 fair value of Sub − $775,000 fair value of Sub’s net assets).
Since the carrying value of the goodwill exceeds the implied value of the goodwill, an
impairment loss of $25,000 is recognized ($200,000 goodwill carrying value − $175,000
implied goodwill) thereby reducing goodwill to $175,000.
IFRS (one-step approach):
Goodwill impairment and loss under IFRS is 980,000 (carrying value) − 950,000 (fair value) =
$30,000.
Bargain Purchase
In rare cases, acquisition purchase price is less than the fair value of net assets acquired.
Both IFRS and U.S. GAAP require that the difference between fair value of net assets
and purchase price be recognized as a gain in the income statement.
MODULE QUIZ 14.8
To best evaluate your performance, enter your quiz answers online.
1. According to U.S. GAAP, goodwill is considered impaired if the:
A. implied goodwill at the measurement date exceeds the carrying value of
goodwill.
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B. carrying value of the reporting unit is greater than fair value of the
reporting unit.
C. goodwill can be separated from the business and valued separately.
2. Adam Corporation acquired Hardy Corporation recently using the acquisition
method. Adam is preparing to report its year-end results to include Hardy
according to IFRS. Which of the following statements regarding goodwill is most
accurate?
A. Adam would amortize its goodwill over no more than 20 years.
B. Adam would test its goodwill annually to ensure the carrying value is not
greater than the recoverable amount.
C. Adam would test its goodwill annually to ensure the fair value is not greater
than the carrying value.
MODULE 14.9: JOINT VENTURES
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Joint Ventures
Recall that a joint venture is an entity in which control is shared by two
or more investors. Joint ventures are created in various legal, operating,
and accounting forms and are often used to invest in foreign markets, special projects,
or risky ventures. Both U.S. GAAP and IFRS require the equity method of accounting
for joint ventures.
In rare circumstances, the proportionate consolidation method may be allowed under
U.S. GAAP and IFRS. Proportionate consolidation is similar to a business acquisition,
except the investor (venturer) only reports the proportionate share of the assets,
liabilities, revenues, and expenses of the joint venture. Since only the proportionate
share is reported, no minority owners’ interest is necessary.
Let’s return to our earlier acquisition example. Recall that Company P acquired 80% of
Company S on January 1, 2010, for $8,000 cash. Figure 14.8 compares the
proportionate consolidation method and the equity method on the post-acquisition
balance sheet of Company P.
Figure 14.8: Balance Sheet Comparison of Proportionate Consolidation and Equity
Methods
Company P Post-Acquisition Balance Sheet
Proportionate Consolidation Method
Equity Method
$52,800
$40,000
January 1, 2010
Current assets
Investment in S
8,000
Other assets
38,400
32,000
Total
$91,200
$80,000
Current liabilities
$51,200
$40,000
Common stock
28,000
28,000
Retained earnings
12,000
12,000
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Retained earnings
12,000
12,000
Total
$91,200
$80,000
Under proportionate consolidation, Company P’s current assets are $52,800 [$48,000 P
current assets − $8,000 cash paid + ($16,000 S current assets × 80%)].
With proportionate consolidation, Company P reports its 80% share of each of
Company S’s assets and liabilities. No minority ownership interest is necessary. Just
like a regular consolidation, Company S’s equity is ignored.
Notice that proportionate consolidation results in higher assets and liabilities, compared
to the equity method, but stockholders’ equity (or net assets) is the same.
Figure 14.9: Income Statement Comparison of Proportionate Consolidation and Equity
Methods
Company P Income Statement
Proportionate Consolidation Method
Equity Method
Revenue
$76,000
$60,000
Expenses
52,800
40,000
Operating income
$23,200
$20,000
Year ended December 31, 2010
Equity in income of S
3,200
Net income
$23,200
$23,200
With proportionate consolidation, Company P reports its 80% share of Company S’s
revenues and expenses. Once again, no minority ownership interest is necessary.
Notice that proportionate consolidation results in higher revenues and expenses
compared to the equity method, but net income is the same.
MODULE QUIZ 14.9
To best evaluate your performance, enter your quiz answers online.
Use the following information to answer Questions 1 through 3.
Company C owns a 50% interest in a joint venture, JVC, and accounts for it using the
equity method. JVC’s assets and liabilities have a book value equal to their fair value.
They have each reported the following 2017 financial results.
Balance Sheets
Company C
JVC
Cash
$1,550
$300
Accounts receivable
3,500
700
Inventory
3,000
800
Fixed assets
5,000
2,600
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Investment in JVC
400
Total assets
$13,450
$4,400
Accounts payable
$3,500
$1,200
Long-term debt
4,000
2,400
Equity
5,950
800
$13,450
$4,400
Total liabilities and equity
Income Statements
Revenues
Equity in JVC earnings
Company C
JVC
$17,430
$2,800
100
Cost of goods sold
7,000
2,000
Other expenses
9,600
600
Net income
$930
$200
1. Assuming consolidation using the acquisition method, Company C’s stockholders’
equity at the end of 2017 is closest to:
A. $5,950.
B. $6,350.
C. $6,750.
2. Assuming consolidation using the acquisition method, Company C’s total assets
at the end of 2017 is closest to:
A. $15,250.
B. $15,650.
C. $17,450.
3. Assuming proportionate consolidation, Company C’s cost of goods sold and net
income for the year ended 2017 are closest to:
Cost of goods sold
A. $8,000
B. $9,000
C. $8,000
Net income
$930
$1,030
$830
4. According to U.S. GAAP, which of the following statements about the method
used to account for a joint venture whereby each party owns 50% is most
accurate?
A. The investor can choose between the acquisition method and the equity
method.
B. The equity method is required.
C. The acquisition method is required.
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MODULE 14.10: SPECIAL PURPOSE ENTITIES
Special Purpose and Variable Interest
Entities
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A special purpose entity (SPE) is a legal structure created to isolate
certain assets and liabilities of the sponsor. An SPE can take the form of a corporation,
partnership, joint venture, or trust. The typical motivation is to reduce risk and thereby
lower the cost of financing. SPEs are often structured such that the sponsor company
has control over the SPE’s finances or operating activities while third parties have
controlling interest in the SPE’s equity.
In the past, SPEs were often maintained off-balance-sheet, thereby enhancing the
sponsor’s financial statements and ratios.
The FASB uses the term variable interest entity (VIE) to describe a special purpose
entity that meets certain conditions. According to FASB ASC Topic 810,
Consolidation, a VIE is an entity that has one or both of the following characteristics:
1. At-risk equity that is insufficient to finance the entity’s activities without
additional financial support.
2. Equity investors that lack any one of the following:
Decision making rights.
The obligation to absorb expected losses.
The right to receive expected residual returns.
If an SPE is considered a VIE, it must be consolidated by the primary beneficiary. The
primary beneficiary is the entity that absorbs the majority of the risks or receives the
majority of the rewards.
PROFESSOR’S NOTE
In a VIE, the capital source labeled as stockholders’ equity is not truly equity, as the amount
is insufficient to have the risk/return characteristics of equity. Generally, in these companies,
“variable interest” refers to a stake in the company (or guarantees given) by the primary
beneficiary. This stake has the same economic characteristics as “normal” equity.
The IASB continues to use the term special purpose entity. According to IFRS 10,
Consolidated Financial Statements, the sponsoring entity must consolidate if it controls
the SPE.
EXAMPLE: Special purpose entity
Company P, a textile manufacturer, wants to borrow $100 million. It has two options:
Company P’s balance sheet before the borrowing is provided below:
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Prepare company P’s balance sheet under both options assuming that the SPE in option B meets the
requirements for consolidation.
Answer:
Option A: Company P’s cash and debt will both increase by the new borrowing of $100 million.
Company P’s balance sheet after the borrowing:
Option B: Company P’s (nonconsolidated) balance sheet will reflect a reduction in accounts
receivable of $100 million and an increase in cash by the same amount.
Company P’s balance sheet after the sale of accounts receivable to the SPE:
SPE’s balance sheet after purchase of accounts receivable and bank loan:
After consolidation, the SPE’s debt gets included with company P’s debt, and accounts receivable
for company P increase by the same amount.
Company P’s balance sheet after consolidation:
The balance sheet of company P under either option is the same. Company P cannot hide the
borrowing “off the books.”
OTHER ISSUES IN BUSINESS COMBINATIONS THAT
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OTHER ISSUES IN BUSINESS COMBINATIONS THAT
WEAKEN COMPARABILITY
Contingent Assets and Liabilities
Under IFRS, only contingent liabilities whose fair value can be measured reliably are
recognized at the time of acquisition. (Contingent assets are never recognized.) In
subsequent periods, contingent liabilities are measured at the higher of the value
initially recognized, or the best estimate of the amount needed to settle the liabilities.
U.S. GAAP divides contingent assets and liabilities into contractual and noncontractual.
Contractual contingent assets and liabilities are recorded at their fair values on the
acquisition date. Noncontractual contingent assets are also recorded if, “more likely
than not” they meet the definition of an asset or liability. Subsequently, measurement of
contingent liabilities is similar under IFRS, while contingent assets are recognized at the
lower of the initial value and the best estimate of the future settlement amount.
Contingent Consideration
If the terms of the acquisition involve a contingent consideration (e.g., a specific extra
amount is payable to the former shareholders of the subsidiary if certain earnings or
revenue targets are met), such consideration is recognized at fair value under both IFRS
and U.S. GAAP as an asset, liability, or equity. Subsequent changes in value are
recognized in the income statement, unless the value was originally classified in equity
(any changes then settle within equity and not via the income statement).
In-Process R&D
In-process R&D is capitalized as an intangible asset and included as an asset under both
U.S. GAAP and IFRS. In-process R&D is subsequently amortized (if successful) or
impaired (if unsuccessful).
Restructuring Costs
Restructuring costs are expensed when incurred—and not capitalized as part of the
acquisition cost—under both IFRS and U.S. GAAP.
LOS 14.c: Analyze how different methods used to account for intercorporate
investments affect financial statements and ratios.
CFA® Program Curriculum, Volume 2, page 34
The effects of the choice of accounting methods on reported financial results have been
covered earlier in this topic review, so we won’t repeat the discussion here. Instead,
we’ll compare the effects of the equity method, the proportionate consolidation method,
and the acquisition method.
There are four important effects on the balance sheet and income statement items that
result from the choice of accounting method (in most situations):
1. All three methods report the same net income.
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2. Equity method and proportionate consolidation report the same equity.
Acquisition method equity will be higher by the amount of minority interest.
3. Assets and liabilities are highest under the acquisition method and lowest under
the equity method; proportionate consolidation is in-between.
4. Revenues and expenses are highest under the acquisition method and lowest under
the equity method; proportionate consolidation is in-between.
Figure 14.10: Reported Financial Results from Different Accounting Methods
Equity Method
Proportionate
Consolidation
Acquisition
Method
Net profit
margin
Higher—sales are lower and net income is
the same
In-between
Lower
ROE
Higher—equity is lower and net income is
the same
Same as equity method
Lower
ROA
Higher—net income is the same and assets
are lower
In-between
Lower
MODULE QUIZ 14.10
To best evaluate your performance, enter your quiz answers online.
1. A company accounts for its investment in a subsidiary using the equity method.
The reported net profit margin is 14%. An analyst adjusts the financials and
determines that the company’s own net profit margin is 8% while the subsidiary’s
profit margin is 10%. The net profit margin based on consolidation would most
likely be:
A. less than 8%.
B. more than 14%.
C. between 8% and 14%.
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KEY CONCEPTS
LOS 14.a
Accounting for investments:
Ownership
Less than 20%
(investments in financial
assets)
20%–50%
(investments in
associates)
More than 50%
(business combinations)
Degree of
Influence
Accounting Treatment
No significant
influence
Held-to-maturity, fair value through profit or loss,
available-for-sale
Significant
influence
Equity method
Control
Acquisition method
Investments in financial assets: Dividends and interest income are recognized in the
investor’s income statement. Held-to-maturity securities are reported on the balance
sheet at amortized cost. Subsequent changes in fair value are ignored. Fair value
through profit or loss securities are reported at fair value, and the unrealized gains and
losses are recognized in the income statement. Available-for-sale securities are also
reported at fair value, but the unrealized gains and losses are reported in stockholders’
equity.
Investments in associates/joint ventures: With the equity method, the proportionate
share of the investee’s earnings increase the investor’s investment account on the
balance sheet and are recognized in the investor’s income statement. Dividends received
reduce the investment account. Dividends received are not recognized in the investor’s
income statement under the equity method. In rare cases, proportionate consolidation
may be allowed. Proportionate consolidation is similar to a business combination,
except the investor only includes the proportionate share of the assets, liabilities,
revenues, and expenses of the joint venture. No minority owners’ interest is required.
Business combinations: In an acquisition, all of the assets, liabilities, revenues, and
expenses of the subsidiary are combined with the parent. Intercompany transactions are
excluded. When the parent owns less than 100% of the subsidiary, it is necessary to
create a noncontrolling interest account for the proportionate share of the subsidiary’s
net assets and net income that is not owned by the parent.
Under IFRS, the sponsor of a special purpose entity (SPE) must consolidate the SPE if
their economic relationship indicates that the sponsor controls the SPE. U.S. GAAP
requires that a variable interest entity (VIE) must be consolidated by its primary
beneficiary.
LOS 14.b
Differences between IFRS and U.S. GAAP treatment of intercorporate investments
include:
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Unrealized foreign exchange gains and losses on available-for-sale securities are
recognized on the income statement under IFRS and as other comprehensive
income under U.S. GAAP.
IFRS permits either the partial goodwill or full goodwill method to value goodwill
and noncontrolling interest in business combinations. U.S. GAAP requires the full
goodwill method.
LOS 14.c
The effects of the equity method versus the acquisition method:
Both report the same net income.
Acquisition method equity will be higher by the amount of minority interest.
Assets and liabilities are higher under the acquisition method.
Sales are higher under the acquisition method.
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ANSWER KEY FOR MODULE QUIZZES
Module Quiz 14.1
1. A Usually an ownership interest between 20% and 50% would indicate the ability
to significantly influence. However, in this case, Tall is unable to influence Short
as evidenced by its failure to obtain board representation; thus, Tall’s ownership
interest should be considered an investment in financial assets. (LOS 14.a)
Module Quiz 14.2
1. B Initially, the carrying value of all security investments is cost.
initial cost = $950 + 250 = $1,200 (LOS 14.a)
2. B Both available-for-sale and fair value through profit or loss securities are
carried at market value on the balance sheet. Also, both classifications call for
recognition of unrealized losses and gains. Market value at t = 1 is $850 + $180 =
$1,030. Unrealized loss is ($850 – $950) + ($180 – $250) = –$170. Note that the
recognition differs. With available-for-sale securities, the recognition is only on
the balance sheet. With fair value through profit or loss securities, the recognition
impacts the income statement. (LOS 14.a)
3. C The increase in value requires that investment securities be written up to $900 +
$350 = $1,250. Because these are equity securities, the held-to-maturity
classification is not available. (LOS 14.a)
4. A Classifying the shares as trading requires both realized and unrealized gains and
losses to be recognized on the income statement. As a result, this would have the
effect of greater reported earnings volatility. There is actually a $220 unrealized
gain between t = 1 and t = 2; the gain is unrealized because the shares were not
actually sold. The net gain of $50 between the acquisition date and t = 2 is
unrealized; therefore, by classifying as available-for-sale, the gain is not
recognized on the income statement (it goes directly to equity). Classification as
either trading or available-for-sale securities results in the same fair market value
of $1,250 reported on the balance sheet at t = 2. (LOS 14.a)
5. B Debt securities held-to-maturity are securities that a company has the positive
intent and ability to hold to maturity. They are carried at amortized cost ($1,200),
and no unrealized or realized gains or losses are recognized until disposition.
Because these securities were purchased at par, there is no amortization of
premium/discount. (LOS 14.a)
Module Quiz 14.3, 14.4
1. A With the equity method, the proportional share of the affiliate’s income (%
ownership × affiliate earnings) is reported on the investor’s income statement.
(Module 14.4, LOS 14.a)
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2. B $1,500,000 + 0.4($500,000 − $125,000) = $1,650,000. (Module 14.4, LOS
14.a)
3. C $500,000 × 0.4 = $200,000; dividends are not included in income under the
equity method. (Module 14.4, LOS 14.a)
4. A $125,000 × 0.4 = $50,000; the dividend is cash flow = $50,000. (Module 14.4,
LOS 14.a)
Module Quiz 14.5, 14.6
1. B Total assets = $1,200,000 + $360,000 − $120,000 = $1,440,000. (Module 14.6,
LOS 14.a)
2. B Minority interest income = $60,000(0.2) = $12,000.
Consolidated net income (after minority interest income is subtracted) = $300,000
+ $60,000 − $12,000 = $348,000. (Module 14.5, LOS 14.a)
3. B The beginning balance of the minority interest is $30,000 ($150,000 S equity ×
20%). The minority interest is increased by the minority share of Company S’s
income of $12,000 ($60,000 × 20%) and is decreased by the minority share of the
dividends paid by Company S of $3,000 ($15,000 × 20%). Thus, the ending
balance is $39,000 ($30,000 + $12,000 − $3,000). Note that the value of goodwill
at the time of acquisition is zero; hence, there is no need to specify whether full or
partial goodwill accounting is used. (Module 14.5, LOS 14.a)
Module Quiz 14.7
1. A $6,000,000 + 0.2(–$450,000) − 0.2($600,000) = $5,790,000. (Module 14.6,
LOS 14.a)
2. A 0.2(–$450,000) = –$90,000. (Module 14.7, LOS 14.a)
3. A After removing the investment gains in 2016 and 2017, operating income is
$500 each year. Based on a growth trend of 0%, the appropriate operating income
forecast for 2018 is also $500.
2016
2017
$1,000
$1,140
Operating costs
500
640
Adjusted operating income
500
500
Sales and operating revenues
(Module 14.7, LOS 14.a)
Module Quiz 14.8
1. B In testing goodwill for impairment, the carrying value of the reporting unit
(including goodwill) is compared to the fair value of the reporting unit. Once an
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impairment has been detected, the loss is equal to the difference in the book value
of the goodwill and the implied value of the goodwill. (LOS 14.a)
2. B Adam is required to perform an annual impairment test. The carrying value
cannot exceed the fair value; if it does, then an impairment has taken place and the
goodwill must be written down. (LOS 14.a)
Module Quiz 14.9
1. B Company C would include minority interest (50% of $800) along with its own
equity of $5,950 in the consolidated financial statements. (Module 14.6, LOS
14.a)
2. C Company C would include all the assets of JVC and remove its equity
investment in the consolidated balance sheet. $13,450 − $400 + $4,400 = $17,450.
(Module 14.7, LOS 14.a)
3. A COGS = $7,000 Company C + 50% of $2,000 JVC = $8,000.
Net income of $930 is not affected by proportionate consolidation. (Module 14.9,
LOS 14.a)
4. B Under U.S. GAAP (and IFRS), equity method is required to be used to account
for joint ventures. Only in rare cases is proportionate consolidation allowed.
(Module 14.9, LOS 14.b)
Module Quiz 14.10
1. C The equity method typically yields a higher measure of net profit margin.
Consolidation is most likely to result in a net profit margin somewhere between
the profit margins of the two entities. (LOS 14.c)
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The following is a review of the Financial Reporting and Analysis (1) principles designed to address the
learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned
Reading #15.
READING 15: EMPLOYEE
COMPENSATION: POST-EMPLOYMENT
AND SHARE BASED
Study Session 5
EXAM FOCUS
This is a complicated topic, but don’t be intimidated. Accounting for pension plans may
be complex, but the economic reasoning is not too difficult to grasp. Despite
convergence between U.S. GAAP and IFRS, significant differences remain, particularly
with respect to recognition of periodic pension cost in income statement versus in OCI.
You should be able to explain how reported results are affected by management’s
assumptions. You should also be able to adjust the reported financial results for
economic reality by calculating total periodic pension cost. Share-based compensation
is also introduced. Compensation expense is based on fair value on the grant date, and it
is often necessary to use an option pricing model to estimate fair value. Make sure you
understand the effects of changing the model inputs on fair value.
MODULE 15.1: TYPES OF PLANS
LOS 15.a: Describe the types of post-employment benefit plans and
implications for financial reports.
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CFA® Program Curriculum, Volume 2, page 77
A pension is a form of deferred compensation earned over time through employee
service. The most common pension arrangements are defined-contribution plans and
defined benefit plans.
A defined contribution plan is a retirement plan whereby the firm contributes a certain
sum each period to the employee’s retirement account. The firm’s contribution can be
based on any number of factors including years of service, the employee’s age,
compensation, profitability, or even a percentage of the employee’s contribution. In any
event, the firm makes no promise to the employee regarding the future value of the